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Hedge fund costs add up to bad math

Date: Saturday, June 13, 2009
Author: Tom Bradley, News from Globe and Mail

Tom Bradley is president of Steadyhand Investment Funds Inc. tbradley@steadyhand.com

I'm not a hedge fund manager, but I find their place in the industry to be forever fascinating. Indeed, this week I went so far as to publicly debate the proposition "Hedge funds are dead" with Toreigh Stuart of Man Investments, a hedge fund conglomerate. Due to weak debating skills and a stacked audience, I lost, but I like to think I'm smarter for it.

Hedge funds sound more exotic and mysterious than they really are. They are investment managers that own stocks and bonds just like the rest of us. There are two key factors that distinguish them, however. They charge more for their services and they pursue a wider range of strategies.

Because the term hedge fund covers various types of managers, many people view the fee factor as the only differentiator. Hedgies charge their clients an annual base fee just like conventional managers (traditionally 2 per cent), but they also collect a portion of the profits. The performance bonus has historically been 20 per cent of any returns above a defined level. I use the words "traditionally" and "historically" because fees are currently in a state of flux.

To generate attractive returns that justify a premium fee, hedgies bring more tools to the challenge. They can short stocks if they want to benefit from price declines. They often use leverage. And they can invest more freely in derivatives. In general, they are less constrained than conventional managers, which allows them to go further afield in pursuit of returns.

For example, to generate an 8-per-cent annual return, a conventional manager can buy and hold a portfolio of stocks, which subjects clients to all the volatility that goes along with equity ownership. For long-term investors, there's nothing wrong with that.

Hedgies may choose to do that too, and often do, but they can also take a more stable, lower-return strategy and combine it with some leverage. By amping up a strategy that's perceived to be more reliable with the use of debt, the manager hopes to achieve that same 8-per-cent return. An example of this would be to borrow short-term money cheaply and invest it in longer-dated, higher-yielding corporate bonds or mortgages.

The alternative strategy represents a unique set of risks and will provide a different pattern of returns, but there is no new magical return being invented in the long run. In recent years, some of these strategies were perceived to be a free lunch - i.e. equity-like returns with bond-like volatility - but that proved to be misguided. It was just a case where the risks associated with leverage, bond defaults and illiquidity were underappreciated for a brief, irrational moment.

The fee and tool kit criteria encompass a broad range of investment managers that pursue strategies with names like market neutral, long/short equity, merger arbitrage, event-driven and distressed debt. I should note, they also capture some conventional managers that just want to charge more.

When we look at the investment industry as a whole, logic and mathematics tells us that for every investor who beats the market, someone has to lose. It's a zero-sum game. The total value-added (returns in excess of index returns) nets out to zero, minus any costs. (Note: The math is not quite that simple. We could have two managers winning by a little and one losing by a lot. And the use of leverage prevents the equation from totalling exactly zero.)

Behind their immense growth in the past decade is an underlying assumption that hedgies can generate returns that more than offset the fees they're charging. And in so doing, transfer added-value, or alpha as it's called, away from the conventional managers.

There are some good reasons that suggest this could happen. The extra tools along with fewer constraints and the ability to attract the "best and the brightest" are real advantages. But while there will always be individual firms that earn their fee each year (since the debate, I've had friends and foes not-so-subtly remind me of which ones they are), the question remains, can hedgies over all steal away enough alpha to justify the fees?

No amount of research, statistics or beer will change Mr. Stuart's and my view on this issue. Both sides can produce numbers that support their argument, and I'm not here to get in the last word.

Where there is no debate, however, is how the "collective" client (all investors combined) is affected. As capital shifts from low-fee funds to high-fee products (hedge funds and other structured products), the costs go up while the total added-value remains the same.

That's bad math any way you look at it.